Classical Theory of International Trade:
The Classical theory of international trade is given by Adam Smith and David Ricardo. The theory explains the condition of international trade specialization and benefits of trade.According to the theory international trade is a case of geographical speculation. Different countries have different set of resources. In this process a country may have more of a resource. The abundance of a resource gives cost advantage in the production of a commodity. The cost advantage is the basic of specialization and international trade.Assumptions:1. The theory of international trade is based on the labor theory of value. With this, value of any product can be explained in term of labor units.2. It is a 2x2 model, 2 countries and 2 commodities.
3. The theory assumes barter system of exchange.
4. It is a case of free trade without any restriction from either country.
5. No transport cost.
6. Perfect competition and full employment.
7. Factors of production are perfectly mobile within a country and immobile between countries.
According to the classical theory of international trade, every country will produce their commodities for the production of which it is most suited in terms of its natural endowments climate quality of soil, means of transport, capital, etc. It will produce these commodities in excess of its own requirement and will exchange the surplus with the imports of goods from other countries for the production of which it is not well suited or which it cannot produce at all. Thus all countries produce and export these commodities in which they have cost advantages and import those commodities in which they have cost disadvantages.
1. Mercantilism (William Petty, Thomas Mun and Antoine de Montchrétien model)
2. The Absolute Advantage (Adam Smith model)
3. The Comparative Advantage (David Ricardo model)
1). Mercantilism (William Petty, Thomas Mun and Antoine de Montchrétien model): Mercantilism is a philosophy from about 300 years ago. The base of this theory was the “commercial revolution”, the transition from local economies to national economies, from feudalism to capitalism, from a rudimentary trade to a larger international trade.
Mercantilism was the economic system of the major trading nations during the 16th, 17th, and 18th century, based on the premise that national wealth and power were best served by increasing exports and collecting precious metals in return. It superseded the medieval feudal organization in Western Europe, especially in Holland, France, United Kingdom, Belgium, Portugal and Spain. The monarch controlled everything. Their policy was to export in the countries that they controlled and not to import (to have a positive Balance of Trade).
Geographical discoveries not only stimulated the international trade, but also produced an affluent flow of gold and silver, which could be used to encourage the economy based on money and prices.
The state exercised much control over economic life, chiefly through corporations and trading companies. Production was carefully regulated with the object of securing goods of high quality and low cost, thus enabling the nation to hold its place in foreign markets.
The theory states that the world only contained a fixed amount of wealth and that to increase a country wealth; one country had to take some wealth from another, either through having a higher import/export ratio.
So, this tendency, to export more and import less and to receive in exchange gold (the deficit is paid in gold) is called MERCANTILISM.
The theory was criticized by the newly appeared class. More money was associated with less products and inflation. The standard of living is weaker. Mercantilist ideas did not decline until the coming of the Industrial Revolution and of laissez-faire.
2) The Absolute Advantage (Adam Smith model):
The main concept of absolute advantage is generally attributed to Adam Smith for his 1776 publication An Inquiry into the Nature and Causes of the Wealth of Nations in which he countered mercantilist ideas. Smith argued that it was impossible for all nations to become rich simultaneously by following mercantilism because the export of one nation is another nation’s import and instead stated that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage.Smith also stated that the wealth of nations depends upon the goods and services available to their citizens, rather than their gold reserves. While there are possible gains from trade with absolute advantage, the gains may not be mutually beneficial. Comparative advantage focuses on the range of possible mutually beneficial exchanges.
In the second half of the XVIII century, mercantilist policies became an obstacle for the economic progress. Adam Smith (father of liberalism and economical science) brought the argument in his book “The Wealth of Nations”, published in 1776, that the mercantilist policies favorised producers and disadvantaged the interests of consumers.
Adam Smith’s theory starts with the idea that export is profitable if you can import goods that could satisfy better the necessities of consumers instead of producing them on the internal market.
The essence of Adam Smith theory is that the rule that leads the exchanges from any market, internal or external, is to determine the value of goods by measuring the labour incorporated in them.
In order to demonstrate its theory, Adam Smith analyzed for the beginning country A, using one factor of production, the productivity of labour, evaluated in the necessary of hours needed to produce a unit of measure of the products X and Y. He used a unifactorial system of economy.
Symbolizing H-hours, L-labour, the unitary necessary of labour for product X is HLX and for Y HLY.
Because all the economies have limited resources, there are limits in the level of production, and if a country wants to produce much of one product it has to give up producing another goods, existing in this case renounce of trade. Renounces can be illustrated by a graphic.
THE PRODUCTION POSSIBILITY FRONTIER
We have a single factor of production- labour, which results in productivity.This country has a resource of labour of 8+4=12 hours.
- with 4 hours of labour the country can produce 1 kilo of cheese.
- with 8 hours of labour the country can produce 1 liter of wine
The production possibility frontier illustrates the variety of the mixing of goods that can be produced by the economy. The opportunity cost is the number of measure units of product Y to which the economy has to give up in order to produce one supplementary unit of product X.
Country A is more productive th B in the production of X and it has an Country A is more productive th B in the production of X and it has an absolute advantage in this product and country B is more productive than A in producing product Y. It is reasonable and in the benefit of 2 countries to concentrate all resources
of labor to the product for which they have comparative advantage. After specialization, exchanging products, both countries gain from trade.
3). The Comparative Advantage (David Ricardo model):
In 1817, David Ricardo, an English political economist, contributed theory of comparative advantage in his book 'Principles of Political Economy and Taxation'. This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade.
David Ricardo theory demonstrates that countries can gain from trade even if one of them is less productive then another to all goods that it produce.
David Ricardo stated a theory that other things being equal a country tends to specialise in and exports those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly the country's imports will be of goods having relatively less comparative cost advantage or greater disadvantage.
As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of comparative advantage expressed in labour hours by the following table.
Portugal requires less hours of labour for both wine and cloth. One unit of wine in Portugal is produced with the help of 80 labour hours as above 120 labour hours required in England. In the case of cloth too, Portugal requires less labour hours than England. From this it could be argued that there is no need for trade as Portugal produces both commodities at a lower cost. Ricardo however tried to prove that Portugal stands to gain by specialising in the commodity in which it has a greater comparative advantage. Comparative cost advantage of Portugal can be expressed in terms of cost ratio.
• Cost ratios of producing Wine and Cloth ↓
Portugal has advantage of lower cost of production both in wine and cloth. However the difference in cost, that is the comparative advantage is greater in the production of wine (1.5 — 0.66 = 0.84) than in cloth (1.11 — 0.9 = 0.21).
Even in the terms of absolute number of days of labour Portugal has a large comparative advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 > 10). Accordingly Portugal specialises in the production of wine where its comparative advantage is larger. England specialises in the production of cloth where its comparative disadvantage is lesser than in wine.
• Comparative Cost Benefits Both Participants ↓
Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had clear cost advantage in both commodities. To prove it, let us work out the internal exchange ratio.
Let us assume these 2 countries enter into trade at an international exchange rate (Terms of Trade) 1 : 1.
At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth.
Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.
In this example, Portugal specialises in wine where it has greater comparative advantage leaving cloth for England in which it has less comparative disadvantage.
Thus comparative cost theory states that each country produces & exports those goods in which they enjoy cost advantage & imports those goods suffering cost disadvantage.
References:
1) http://cis01.central.ucv.ro/iba/files/int_ec2.pdf
2) http://kalyan-city.blogspot.com/2011/02/ricardos-theory-of-comparative.html
3) http://en.wikipedia.org/wiki/Absolute_advantage
The Classical theory of international trade is given by Adam Smith and David Ricardo. The theory explains the condition of international trade specialization and benefits of trade.According to the theory international trade is a case of geographical speculation. Different countries have different set of resources. In this process a country may have more of a resource. The abundance of a resource gives cost advantage in the production of a commodity. The cost advantage is the basic of specialization and international trade.Assumptions:1. The theory of international trade is based on the labor theory of value. With this, value of any product can be explained in term of labor units.2. It is a 2x2 model, 2 countries and 2 commodities.
3. The theory assumes barter system of exchange.
4. It is a case of free trade without any restriction from either country.
5. No transport cost.
6. Perfect competition and full employment.
7. Factors of production are perfectly mobile within a country and immobile between countries.
According to the classical theory of international trade, every country will produce their commodities for the production of which it is most suited in terms of its natural endowments climate quality of soil, means of transport, capital, etc. It will produce these commodities in excess of its own requirement and will exchange the surplus with the imports of goods from other countries for the production of which it is not well suited or which it cannot produce at all. Thus all countries produce and export these commodities in which they have cost advantages and import those commodities in which they have cost disadvantages.
Types of Cost Difference in Production:
The classical theory of international trade is explained is 3 parts as Economists speak about three types of cost difference in production, they are
- Absolute cost difference,
- Equal cost difference, and
- Comparative cost difference.
1. Mercantilism (William Petty, Thomas Mun and Antoine de Montchrétien model)
2. The Absolute Advantage (Adam Smith model)
3. The Comparative Advantage (David Ricardo model)
1). Mercantilism (William Petty, Thomas Mun and Antoine de Montchrétien model): Mercantilism is a philosophy from about 300 years ago. The base of this theory was the “commercial revolution”, the transition from local economies to national economies, from feudalism to capitalism, from a rudimentary trade to a larger international trade.
Mercantilism was the economic system of the major trading nations during the 16th, 17th, and 18th century, based on the premise that national wealth and power were best served by increasing exports and collecting precious metals in return. It superseded the medieval feudal organization in Western Europe, especially in Holland, France, United Kingdom, Belgium, Portugal and Spain. The monarch controlled everything. Their policy was to export in the countries that they controlled and not to import (to have a positive Balance of Trade).
Geographical discoveries not only stimulated the international trade, but also produced an affluent flow of gold and silver, which could be used to encourage the economy based on money and prices.
The state exercised much control over economic life, chiefly through corporations and trading companies. Production was carefully regulated with the object of securing goods of high quality and low cost, thus enabling the nation to hold its place in foreign markets.
The theory states that the world only contained a fixed amount of wealth and that to increase a country wealth; one country had to take some wealth from another, either through having a higher import/export ratio.
So, this tendency, to export more and import less and to receive in exchange gold (the deficit is paid in gold) is called MERCANTILISM.
The theory was criticized by the newly appeared class. More money was associated with less products and inflation. The standard of living is weaker. Mercantilist ideas did not decline until the coming of the Industrial Revolution and of laissez-faire.
2) The Absolute Advantage (Adam Smith model):
The main concept of absolute advantage is generally attributed to Adam Smith for his 1776 publication An Inquiry into the Nature and Causes of the Wealth of Nations in which he countered mercantilist ideas. Smith argued that it was impossible for all nations to become rich simultaneously by following mercantilism because the export of one nation is another nation’s import and instead stated that all nations would gain simultaneously if they practiced free trade and specialized in accordance with their absolute advantage.Smith also stated that the wealth of nations depends upon the goods and services available to their citizens, rather than their gold reserves. While there are possible gains from trade with absolute advantage, the gains may not be mutually beneficial. Comparative advantage focuses on the range of possible mutually beneficial exchanges.
In the second half of the XVIII century, mercantilist policies became an obstacle for the economic progress. Adam Smith (father of liberalism and economical science) brought the argument in his book “The Wealth of Nations”, published in 1776, that the mercantilist policies favorised producers and disadvantaged the interests of consumers.
Adam Smith’s theory starts with the idea that export is profitable if you can import goods that could satisfy better the necessities of consumers instead of producing them on the internal market.
The essence of Adam Smith theory is that the rule that leads the exchanges from any market, internal or external, is to determine the value of goods by measuring the labour incorporated in them.
In order to demonstrate its theory, Adam Smith analyzed for the beginning country A, using one factor of production, the productivity of labour, evaluated in the necessary of hours needed to produce a unit of measure of the products X and Y. He used a unifactorial system of economy.
Symbolizing H-hours, L-labour, the unitary necessary of labour for product X is HLX and for Y HLY.
Because all the economies have limited resources, there are limits in the level of production, and if a country wants to produce much of one product it has to give up producing another goods, existing in this case renounce of trade. Renounces can be illustrated by a graphic.
THE PRODUCTION POSSIBILITY FRONTIER
We have a single factor of production- labour, which results in productivity.This country has a resource of labour of 8+4=12 hours.
- with 4 hours of labour the country can produce 1 kilo of cheese.
- with 8 hours of labour the country can produce 1 liter of wine
The production possibility frontier illustrates the variety of the mixing of goods that can be produced by the economy. The opportunity cost is the number of measure units of product Y to which the economy has to give up in order to produce one supplementary unit of product X.
Country A is more productive th B in the production of X and it has an Country A is more productive th B in the production of X and it has an absolute advantage in this product and country B is more productive than A in producing product Y. It is reasonable and in the benefit of 2 countries to concentrate all resources
of labor to the product for which they have comparative advantage. After specialization, exchanging products, both countries gain from trade.
3). The Comparative Advantage (David Ricardo model):
In 1817, David Ricardo, an English political economist, contributed theory of comparative advantage in his book 'Principles of Political Economy and Taxation'. This theory of comparative advantage, also called comparative cost theory, is regarded as the classical theory of international trade.
David Ricardo theory demonstrates that countries can gain from trade even if one of them is less productive then another to all goods that it produce.
David Ricardo stated a theory that other things being equal a country tends to specialise in and exports those commodities in the production of which it has maximum comparative cost advantage or minimum comparative disadvantage. Similarly the country's imports will be of goods having relatively less comparative cost advantage or greater disadvantage.
1. Ricardo's Assumptions :-
Ricardo explains his theory with the help of following assumptions :-- There are two countries and two commodities.
- There is a perfect competition both in commodity and factor market.
- Cost of production is expressed in terms of labour i.e. value of a commodity is measured in terms of labour hours/days required to produce it. Commodities are also exchanged on the basis of labour content of each good.
- Labour is the only factor of production other than natural resources.
- Labour is homogeneous i.e. identical in efficiency, in a particular country.
- Labour is perfectly mobile within a country but perfectly immobile between countries.
- There is free trade i.e. the movement of goods between countries is not hindered by any restrictions.
- Production is subject to constant returns to scale.
- There is no technological change.
- Trade between two countries takes place on barter system.
- Full employment exists in both countries.
- There is no transport cost.
2. Ricardo's Example :-
On the basis of above assumptions, Ricardo explained his comparative cost difference theory, by taking an example of England and Portugal as two countries & Wine and Cloth as two commodities.As pointed out in the assumptions, the cost is measured in terms of labour hour. The principle of comparative advantage expressed in labour hours by the following table.
• Cost ratios of producing Wine and Cloth ↓
Even in the terms of absolute number of days of labour Portugal has a large comparative advantage in wine, that is, 40 labourers less than England as compared to cloth where the difference is only 10, (40 > 10). Accordingly Portugal specialises in the production of wine where its comparative advantage is larger. England specialises in the production of cloth where its comparative disadvantage is lesser than in wine.
• Comparative Cost Benefits Both Participants ↓
Let us explain Ricardian contention that comparative cost benefits both the participants, though one of them had clear cost advantage in both commodities. To prove it, let us work out the internal exchange ratio.
At this rate, England specialising in cloth and exporting one unit of cloth gets one unit of wine. At home it is required to give 1.2 units of cloth for one unit of wine. England thus gains 0.2 of cloth i.e. wine is cheaper from Portugal by 0.2 unit of cloth.
Similarly Portugal gets one unit of cloth from England for its one unit of wine as against 0.89 of cloth at home thus gaining extra cloth of 0.11. Here both England and Portugal gain from the trade i.e. England gives 0.2 less of cloth to get one unit of wine and Portugal gets 0.11 more of cloth for one unit of wine.
In this example, Portugal specialises in wine where it has greater comparative advantage leaving cloth for England in which it has less comparative disadvantage.
Thus comparative cost theory states that each country produces & exports those goods in which they enjoy cost advantage & imports those goods suffering cost disadvantage.
References:
1) http://cis01.central.ucv.ro/iba/files/int_ec2.pdf
2) http://kalyan-city.blogspot.com/2011/02/ricardos-theory-of-comparative.html
3) http://en.wikipedia.org/wiki/Absolute_advantage
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